"Q&A w/MAC"--selected "Trading and Strategy"
optionstrategist.com
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Rearranged for emphasis & ease of reading.
>>>Question:
I established a covered call position.
Very quickly after setting up the position, the stock rallied and now my call is in the money.
Time value didn't decrease much yet as the rally was quick.
I would gladly take or lock-in profit.
If I liquidate the position, I give up half of my profit (as I buy back lot of time value.)
I am not sure about more upside in this stock, so I don't want to roll up.
Any other strategies? J.J.
Answer:
The simplest way to "lock in" profit on a covered write is to buy the put with the same terms as your covered write, while still holding the covered write.
Unfortunately, the put will be priced at approximately the same price as the time value premium of your written call.
Since you indicate that you consider that to be a "lot of" time value premium, you may not be thrilled about that strategy either.
A similar strategy might be to buy a put that is one strike out-of-the-money. This will still leave you with some risk, should the underlying stock collapse, but at least it protects you against a LARGE collapse.
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Number: 460 5/8/01
Question:
When employing a covered call strategy, under what circumstances would the writer expect his stock to be called away prior to expiration? Assume that the underlying equity is non-dividend paying. D.B.
Answer:
The answer is surprisingly simple: you do not need to worry about the stock being called away UNLESS THE OPTION IS TRADING WITH NO TIME VALUE PREMIUM.
Once the option begins to trade at parity (i.e., at a price equal to the stock price minus the striking price), then there is always the chance that a market maker or arbitrageur can buy the option at a slight discount to parity and exercise it for arbitrage purposes.
Once he exercises it, of course, there is a risk that a covered writer could be assigned.
So, if you don't want your stock called away, keep an eye on the amount of time value premium left in the option.
…In fact, more specifically, keep an eye on the BID price of the option.
…Once it is bid at or below parity, then it's time to roll your option if you want to avoid any risk of being assigned.
I realize that, in your question, you assumed no dividend, but I'll throw this in, too.
Sometimes, an option will begin trading at parity just prior to the stock's going ex- and fairly large dividend. So, if you want to avoid being assigned, then also keep an eye on the BID price of the option just prior to any dividend payments.
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Category: Trading and Strategy Number: 223 4/20/99
Question:
Mac; when you are covered and short a call option and the stock drops precipitously in price - what are your best recommendations when you think the stock is a long term buy. Wait? Buy it back and wait? Other ideas? J.B.
Answer:
Sometimes the option premium goes away and can be bought back for nothing, but then you're long the stock and cant really get any time premium without 'rolling down' -- what are your latest thoughts on this situation?
In the book Options As A Strategic Investment, we go into a great amount of detail about covered writing, and accompanying "repair strategies".
Essentially, you are not going to get any further downside protection without rolling down.
So the "normal" procedure would be
...to buy back the calls you're short, and
...sell ones at a lower strike (probably at a later expiration date as well).
I assume your reluctance to do so indicates that you don't really want to sell this particular stock. That is one problem with covered call writing.
If you roll down, you might lock in a loss (although you could always buy the option back at a later date and roll back UP as well if you wanted to).
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Category: Theory and Models Number: 254 5/21/99
Question:
I have always used collars for profit and downside protection.
Why not sell at the money calls and put stop on underlying equity instead? B.S.
Answer:
A collar consists of selling a (out-of-the-money) covered call against stock that is owned and simultaneously purchasing an out-of-the-money put.
...It has limited risk and limited profit potential -- much like a bull spread would have.
Your SECOND strategy, however, does NOT have limited risk.
If you sell an at-the-money call, and then stop yourself out of the stock if it falls in price, you would have a naked call hanging out there when you stop yourself out of the stock (you COULD always cover the call, of course).
But, even worse, what happens if the stock suddenly experiences a large downside gap in price (bad earnings, perhaps).
Your SECOND strategy could lose a great deal, while the collar would only lose the initial, predetermined amount.
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Question:
In McMillan on Options, you discuss using deep in the money options with little or no time value as a substitute for stock; you also discuss diagonal spreads. can you do what amounts to a covered call play by buying a deep in the money call a couple months out and selling an at the money call on a nearby month? B.A.
Answer:
Yes, the strategy you describe is tried by a lot of people.
I'm not sure how successful most feel it is -- especially in this market, where covered writing has cost a lot of people a lot of opportunity.
…I.e., the stocks have advanced so fast that most covered writers left a lot of money on the table by having written a call against their stocks.
Nevertheless, you CAN try it, especially if you feel that the rate of returns from the strategy (which has more leverage than covered writing) will be acceptable.
In fact, some people buy a LEAPS (long-term) option and try to continuously sell short-term calls against it.
…The position actually has some bearish behavior, especially if the stock is near or just above the strike of the short call at expiration.
…In that case, the position may have a negative delta, especially if the long call has a "lot" of time value premium in its price.
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Category: Trading and Strategy Number: 360 3/3/00
Question:
I would like to buy LEAP options and sell shorter term options against them using a higher strike price. I suppose this is a calander spread of sorts. Would this strategy be similar to a Covered Call.You would not own the stock outright, but own the LEAPS as collateral.What kind of margin would normally be required and where could I get more information on this subject? G.P.F.
Answer:
The strategy you describe is actually called a DIAGONAL spread, and it has been asked about in other question on this site.
It IS similar to a covered call write, although the delta of the option that is owned is less than 1.0, so the position can actually perform somewhat bearishly near the strike of the written call.
There is no margin required other than the net debit of the options in the spread.
For more information, see the chapter on LEAPS in the book Options As A Strategic Investment.
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Category: Trading and Strategy Number: 311 12/18/99
Question:
What do you think about writing covered option calls against your long leaps. Ie. writing the near term month after month and how best to know when to write the calls each month? J.E.
Answer:
This is a strategy that is attempted by most LEAPS buyers at some time, usually with only limited success.
First and foremost, you must realize that you are limiting your upside.
...So, if a big move to the upside occurs, you will have to either buy back the written call for a big debit (i.e., loss) or close out your entire spread.
Secondly, knowing "when to write calls each month" is an impossible thing to determine.
...If you could do that, you'd be rich quickly.
Usually, you will find the short-term calls are only expensive for a few months, at most, and then they become cheap.
…If you continue to write them when they are cheap, you are not getting any kind of statistical edge at all and will probably find the stock suddenly moving against you.
I think this strategy is basically the same as covered call writing -- except the downside is more limited with the LEAPS option.
Covered call writing is not a good strategy in this current, volatile, market unless you plan to allow the stock to be called away. Therefore, this LEAPS strategy isn't much better.
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Category: Trading and Strategy Number: 439 12/26/00
Question:
Larry, I am buying leaps and selling current month calls every month. The strategy looks very good. my research shows that this has made a min of 30% annualized over any 2 yr period for the past 20 yrs. Your books which I hold as being the 'bible' shows nothing about this. You talk about selling covered calls, which this is, buying leaps compared to buying the stock and that one call sell calls with a long call as cover. I am looking at this as being of the 'It is too good to be true' type and am even though it is working well, I continuously look for flaws in it. Do you see any flaws or negatives? B.S.
Answer:
This strategy is discussed in Options As A Strategic Investment in the chapter on LEAPS.
There is a fairly theoretical example beginning on page 377.
As with any other bullish strategy (and this IS a bullish strategy), there is downside risk. The risk is smaller than that of owning stock, in absolute dollar terms, but is greater in percentage terms.
So, it depends on how much leverage you use as to whether or not you get in trouble in a severely, long-term bear market.
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Question:
Why do so many options experts advise against selling naked options? Selling naked puts is the same economic position as writing covered calls, and selling naked calls is the same economic position as selling covered puts. I understand that what I said above assumes that you close the entire postion out when the options expire. Am I missing something? R.O.
Answer:
Most experts advise against naked options because of the large percentage risks involved.
Your observations are, of course, correct.
So are we to think naked options are okay because the "conventional" holds that writing covered calls is conservative, or should we consider the other strategies risky because they are the same as selling naked options? I prefer the latter.
So, if an expert is against naked option writing, he should be against covered option writing as well. If that is his position, then he is correct and I agree with him.
Stocks make many large gap moves of undetermined proportions at the most inopportune times.
Therefore, naked stock option writers are constantly being exposed to large risks that they can't control.
…This is the real reason why selling naked stock options is not an acceptable strategy.
…The premiums received do not compensate accurately for the risk taken.
There are many related arguments, such as "it's okay to sell naked puts if you wouldn't mind owning the stock at the lower price when it gets put to you".
Unfortunately, by the time it DOES get put to you, you probably DO mind owning it -- as it's plummeting in price.
Naked option writing of index options mitigates the problems somewhat because they don't have gap moves like stocks do (even futures have less volatility than stocks, although the leverage available with futures is larger than with stocks).
So if you are really enamored with selling naked options, I would stick with index options -- and be sure they are definitely overpriced when you sell them.
If you can't find overpriced ones, then don't sell any until you DO find something that's overpriced.
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Category: Trading and Strategy Number: 384 6/13/00
Question:
I have read your recent criticisms of option selling.
But I like recieving the income from writing covered calls on blue chip stocks.
What do you think of this compromise solution to the tension between high volatility and the desire for covered call income flow? sell covered calls at price x and, with part of the proceeds,buy the same amuont of calls,for the same month, at price x+5.thus if the stock really rallies, you can still profit from most of the rally.i would be grateful to hear your thoughts on this strategy.thank you for your time G.N.L.
Answer:
What you are proposing is to sell a call credit spread (a bear spread) against your long stock holdings.
Actually, this is a strategy that some institutions employ, and I think it has merit.
Obviously, you don't receive as much income as you would from a "straight" covered write, but then you do have the chance to participate in large upside moves, should they occur.
In either case, one must carefully select the width of the spread.
To ALWAYS use a spread that is 5 points wide is probably not a good idea.
Rather in your case of selling the call credit spread against long stock,
… you might want to use technical analysis to see where an upside breakout might occur, and
… buy the call with a striking price just below that breakout level as the long side of your spread.
Institutions also sometimes use a similar strategy on the downside:
...they buy put debit spreads as protection for their stocks.
...When they do this, they are protected down to the LOWER strike price of the debit spread, and
........the spread doesn't cost them as much for protection as would the outright purchase of a put.
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Category: Trading and Strategy Number: 376 5/15/00
Question:
Hello Larry: I am looking at two strategies that I would like to ask if you have reviewed or used. One is to write at the money credit spreads on new highs (puts) and new lows (calls), especially focusing on stocks that are in industry groups that are running or flagging.
The other is to run covered calls on stocks that melt down on high volume based on news. Typically, I look to get in near the close the day after the big down move and hold these for about 5-10 trading days and then get out. I tried this some time ago based on your recommendation on Liposome (after it blew an FDA determination). I have refined it a bit, but I am curiors on your thoughts. Any comments, data, or insights you may have are very welcome. D.S
Answer:
I am much more in favor of your second strategy (covered writes on depressed stocks) than your first.
There are plenty of professionals who look for stocks to get whacked, and then try to sell overpriced, slightly out-of-the-money puts afterwards.
This is equivalent to doing a covered write.
In a broader sense,
...there seems to be merit in ONLY establishing covered call writes in depressed stocks where implied volatility is high,
...and it's fairly common for implied volatility to be high after a stock has suffered a loss, whether from news or just from prolonged selling (a bear market in the stock).
As for your first strategy -- credit spreads on new highs and new lows -- I have not heard of anyone trying that strategy, per se.
However, I can pretty much assure you that you will NOT be getting any theoretical pricing advantage in that strategy as you do with the covered writes.
Puts will not be overpriced when stocks break out to new highs, nor will calls be overpriced when stocks break to new lows (although there's a better chance of the latter that the former).
I'm NOT really a big fan of credit spreads, because
...the heavy commission costs and double bid-asked spreads makes them difficult to trade
...they often have to be held for a longer time than you'd imagine in order for you to make the money you think you should be making.
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Category: Trading and Strategy Number: 377 5/15/00
Question:
What can be done when a naked call has been written and the stock rises (perhaps quickly) past the written strike and beyond the premium collected? Roll to the next month and hope for a price decline in the stock? Or is there a strategy to minimize loss or lock in a small profit or increase the odds of making a profit? I have looked at various combinations of buying, selling, shorting, puts, calls, etc., but cannot see a decent way to salvage such a situation. Other option positions have various repair strategies; does this situation have one, too? T.K.
Answer:
Well, there are a number of things you can do, but if the stock keeps on going straight up you are going to lose a lot of money unless you take your loss, or buy something else that covers the short call. Similar things happen on the downside with naked puts.
The simplest thing that one can do is to roll the call up to the next strike (and perhaps out to the next, or later, expiration month) for a credit. This won't always be available, however.
There are some who recommend rolling up for credits, but that requires increased margin and eventually you will run out of money if you get a Qualcomm (QCOM) or Rambus (RMBS) by the tail.
You can also begin to buy some stock OR in-the-money calls against your short calls to reduce the upside exposure -- perhaps at first only hedge part of your short call position, but if the stock keeps on running then eventually buying enough to hedge your entire short call position.
...The danger in doing this is that if the stock suddenly starts to fall, you are exposed on the downside, for you have essentially converted to a bullish position.
...This can be very damaging psychologically.
Another approach is to buy some out-of-the-money calls to at least limit your risk.
...You don't necessarily have to do this to start with (i.e., you start out with plain naked calls).
...But when things begin to get tight, then buy something out of the money to limit the losses.
...At least THIS way, if the stock then suddenly reverses and falls, you'll at least make back a little money (not much), but you won't be exposed to a downside move as you would have had you bought stock against the short calls.
There is no foolproof answer.
Perhaps the best strategy is a simple one: only sell naked calls when
1) the calls are extremely overpriced,
2) there is no takeover rumor, and
3) a probability calculator indicates that there is less than a 25% chance of the stock ever trading at your striking price.
Even then, allow enough margin for the stock to rally all the way to the strike, and finally -- stop yourself out if the stock goes through the strike and just go on to a new position in a different stock.
...Using this method, you won't get hopelessly tied up in some stock that is going wild on the upside.
...You'd just have a losing trade that you can hopefully make back in some other trade on some other day.
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Category: Trading and Strategy Number: 464 6/10/01
Question:
My question is regarding the diagonal LEAPS spread strategy (long LEAPS calls, write near-term calls).
In some of your other replies to this strategy you mention the risk if the stock takes off (especially due to the difference in the delta of the options).
I have a few ideas that I wonder if they could minimize this.
1. Stick to deep ITM LEAPS whose delta is also close to 1
2. Write less short-term calls than LEAPs you are long (example long 10 LEAPs, write 5 1 month calls)
3. Only write the calls when technical considerations say the stock is overextended (such as stochastic greater than 80)
4. Finally, could you not under most cases (exception being when the stock REALLY TAKES OFF) always roll the short calls forward in time and up in expiration at a net credit or extremely small debit. My reason for doing this strategy is that I am bullish on the underlying in the long-term but see no catalysts for short-term appreciation. M.D.
Answer:
Your suggestions are all good ones.
The first two fall into the category of computing the delta on your net position.
If you calculate the delta of buying a slightly in-the-money LEAPS call and selling an short-term call, you will often find that this position has a negative delta.
Both of your first two suggestions are ways to combat this, and they would work (albeit both at the increase of downside risk).
In fact, if you compute your "position delta" accurately, you may find that buying 10 and selling 7 (or something like that) is the correct number; you can be more accurate than just figuring that "buying 10 and selling 5" won't get you in upside trouble.
As for #3, that's up to you.
Frankly, I not a big believer in stochastics (I guess I've seen too many futures and stocks go through the roof, with the stochastics reading "overbought" all the way up).
#4 is tricky.
It will certainly work for a while, but there are plenty of lawsuits stemming from large stock price rises in the last couple of years in which the calls could NOT be rolled up for a credit.
These lawsuits generally arose when someone not familiar with options was "sold" on covered call over-writing by a broker or advisor. They were generally told that there would not be debits and that the premium from the calls would be extra income.
However, in the big bull market, the "rolling up" eventually got into some fairly serious debits -- mostly as lower strikes were delisted and the advisor was forced to roll up for debits. The customer then saw that they were "losing money" (not really, of course, but they weren't making the kind of money that they would have if the stock had not been written against) and they sued. A number of these cases are pending. Thus, you can't be sure that you'll always be able to roll for credits.
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Question:
I have read the section in your book regarding "rolling for credits" and as a high net-worth individual I believe this concept would apply to me. However, the discussion was general and I have some specific questions. First, how large should my starting positions be relative to my entire portfolio to ensure that I don't run out of available margin? Second, I have been writing very near term options. When it becomes necessary to roll up do you always roll out as far as possible or is it better to write more near-term contracts at a lower premium? Finally, do any of your services help to identify call-selling candidates for this strategy? D.P.
Answer:
For those not familiar with the term:
"Rolling for Credit"
...involves writing covered calls against a portion of a long stock position.
...Then, if the stock moves up, the calls are bought back and a greater number of calls are sold at the higher strike in order to cover the cost of the buyback.
Re your first question: you should never run out of "margin".
When you have written covered calls against your entire stock position, you must let it be called away if it moves higher from there.
In order to determine where "there" is,
...at the beginning you need to decide at what price you would be willing to sell your stock.
...Then you can back into the original number of calls to sell.
Let's say the stock is 30, and you would be willing to sell it at 60 and you have 10,000 shares.
There are 6 strikes between 30 and 60, so you'd be able to roll up (and out) 6 times.
While this could be refined with a model, assume that on each roll, you will be selling 50% more calls, just to cover the cost of the roll.
So 1.5 to the 6th power is about 11.
Hence you would start out writing calls against 1/11th of your stock holdings.
Then, as the stock moved up, you would eventually be fully covered at the 60 strike -- having written for credits all the way up.
Of course, if at any expiration, the stock pauses and that group of options expire worthless, you can re-set your target or just keep on with the same quantities.
Re your second question, when you roll up, I would roll out to an option that is only 1 or 2 months longer-term than the one being bought back.
...This should keep you in the 1.5 ratio described above.
...But, overall it is important to maintain the 1.5 ratio, else you will be fully covered before you get to 60.
We do not identify call-selling opportunities specifically, but there is a complete listing of implied volatilities FREE on this web site (option history page), where you can look for stocks which have options in a high percentile.
...Anything over the 90th percentile would be considered expensive.
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Category: Trading and Strategy Number: 442 3/8/01
Question:
I noticed in your Trading and strategy category (question #385) the use of selling $SPX calls against the stock SPY. When I called the CBOE, they informed me that I coulld not utilize the $SPX in a covered call scenario.Could explain to me how I can use these options in conjuntion with SPY in a hedged position? E.E.
Answer:
If you use them, you will of course be hedged since the underlying is the same thing in both cases.
However, due to margin rules, the options must be considered naked which makes the margin requirement onerous for most traders (unless you happen to have a lot of excess equity in your stock account).
I believe that the exchanges are working on this (since they recently allowed QQQ options to be traded on multiple exchanges), and that fairly soon there will be options on the SPY.
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Category: Trading and Strategy Number: 407 8/28/00
Question:
I want to purchase 10000 sh of LSI @ 38 and sell 100 LSI Jan 03 $40 calls @ 19, using the cash received for the covered calls to satisfy the 50% margin requirement. Do SEC margin rules and brokers permit this type of transaction where the initial cash in the account is $20,000? J.G.
Answer:
Be careful with this strategy.
While it is true that some covered writes -- and this is one of them -- can be done for "free", you still have a lot of risk, plus you will accrue margin interest charges.
The margin requirement for a covered write in a margin account when the option is initially out-of-the-money, as you have described here, is merely 50% of the stock price less the premium from the call.
The margin requirement for a covered write in which the option is IN-the-money is slightly different, but let's defer that discussion for a moment because it doesn't apply directly to your situation here.
Hence, the requirement for your trade is zero!
50% of 38 is 19 points requirement on the stock and that's exactly the amount you're bringing in from the option.
Now, many brokerage firms will require some sort of minimum (perhaps $2000), but they should not really require anything additional on this trade.
Your intention to put up $20,000 should be enough to satisfy them for this 10,000 share covered write.
What you have done here is to create a position with TREMENDOUS leverage.
Your risk is $190,000 if the stock should fall to zero.
In fact, if the stock begins to fall much at all, your brokerage firm will ask for maintenance margin.
Most firms give you a little leeway, but if LSI falls to 35 or lower, you can expect to get a margin call.
And then there will be more margin calls if the stock goes lower than that.
Furthermore, you are borrowing $190,000 to establish this trade (50% of the stock price), so you will be paying interest on that debit balance all during the time that you have this position in place.
Of course, you can make as much as $210,000 here ($400,000 proceeds from the stock being called away at 40, less your initial debit balance), less margin costs and commissions.
As far as "allowing" the transaction, there is no reason why the firm wouldn't allow the trade if it is properly margined.
Now, back to a previous point.
You can't do exactly this same thing with an in-the-money covered call write, because the broker will only "release" 50% of the stock price up to the value of the striking price of the option.
For example, suppose you have this situation: Stock: 50 Jan ('03) 30 LEAPS: 25 A covered write on margin of this call would require a 10-point margin: Requirements: Stock price: 50 less option proceeds: -25 less margin release (50% of strike price or 50% of stock price, whichever is LESS: -15 Net Requirement: 10 points You can apply this same formula to YOUR LSI covered write, though, and see that the requirement is still zero: Stock price 38 less option proceeds -19 less margin release (50% of stock price is the lesser number here) -19 Net Requirement: 0 So, good luck, but be careful with that leverage!
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Category: Trading and Strategy Number: 403 7/28/00
Question:
I have been trying to use a covered call selling strategy in my IRA. Is there more to it than just finding stocks that I am willing to hold and that have expensive option(e.g. NLCS)? If so, what resource is available to identify stocks with the most expensive options on a daily basis? P.J.I.
Answer:
Well, this subject could be very large. BUt here's my concise report: We sell a list of the most expensive option classes (stocks, indices, futures) daily. It costs $100 per month. THere is also a web site called coveredwrites.com or coveredwrite.com or something like that.
HOWEVER, just doing covered writes on the most expensive options may wind up filling your portfolio with junk. You should do some research on the stock, too. For example, if the options are expensive becasue the stock just got creamed (Computer Associates, for example), is there a reason why you too should avoid this stock?
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Category: Trading and Strategy Number: 385 6/18/00
Question:
Are there index based funds on which covered calls can be written? The only one I know of is the Nasdaq 100 (qqq) I would greatly appreciate any info. you could provide. J.G
Answer:
"Funds" is really not the right word.
BUt there are indices upon which covered calls can be written.
You have correctly identified QQQ.
You could also buy the Diamonds (Dow-Jones 30 industrials) on the AMEX and sell the $DJX calls on the CBOE. Or buy the Spiders (SPY) on the AMEX and sell the $SPX calls on the CBOE.
Then, there are HOLDRS, which are the same sort of thing for a smaller set of stocks.
THe INternet HOLDRS (HHH) and the Biotech HOLDRS (BBH) are unit trusts composed of internet stocks and biotech stocks, respectively. They both have listed options.<<< |
